Study with the several resources on Docsity
Earn points by helping other students or get them with a premium plan
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Community
Ask the community for help and clear up your study doubts
Discover the best universities in your country according to Docsity users
Free resources
Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors
An overview of stockholders equity, discussing the advantages and disadvantages of issuing stock, the relationship between income and dividends, and the components of the stockholders equity section of the balance sheet. It covers the concepts of common and preferred stock, par value, and retained earnings.
What you will learn
Typology: Summaries
1 / 17
This page cannot be seen from the preview
Don't miss anything!
Harcourt, Inc. 11-
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-2 Harcourt, Inc.
Financing is available in two forms:
Advantages of issuing stock (Exhibit 11-1):
Disadvantages of issuing stock (Exhibit 11-1):
How Income and Dividends Affect Retained Earnings
For a corporation: Assets = Liabilities + Stockholders' Equity
Two general categories of contributed capital (stock):
Number of shares of stock:
necessarily mean the number of shares currently outstanding
of shares outstanding
Par value is an arbitrary amount stated on the face of the stock certificate and represents the legal capital of the corporation.
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-4 Harcourt, Inc.
Cash (asset) increases and Common Stock and Additional-Paid-in-Capital (both shareholders’ equity accounts) increase.
the property, whichever is most readily determined
Treasury stock is created when a company buys back (repurchases) its own stock sometime after issuing it.
Treasury stock is not outstanding , and has no voting rights.
Purchase of treasury stock:
accounts
Resale of treasury stock:
equity accounts
Retirement of stock : bought back with no intention of reissuing
Retirement account
Cash dividends reduce retained earnings when declared.
CHAPTER 11 — STOCKHOLDERS’ EQUITY
Harcourt, Inc. 11-
When more than one class of stock is outstanding, cash dividends must be allocated between them.
common shareholders
company must avoid diminishing the attractiveness of their common stock when investors see less dividend money available to common shareholders after preferred stockholders receive their allocation
Company may issue shares of its own stock in lieu of paying cash dividends to stockholders.
purposes
the dividend is large
of declaration, since it is considered unlikely to have a material effect on stock price
CHAPTER 11 — STOCKHOLDERS’ EQUITY
Harcourt, Inc. 11-
Issue and repurchase of stock and payment of dividends are financing items.
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-8 Harcourt, Inc.
Lecture Suggestions
LO 1 Ask students to review the assignment for^ LO 2 ,^ Chapter 1 , on forming a corporation. What were the State’s requirements related to the issue of stock?
LO 3 Students will enjoy a discussion at this time of the stock market, including the difference between an issue of stock by the company, and the purchase of stock from another existing stockholder. Many students are unaware that an exchange between existing stockholders has no effect at all on the company’s balance sheet, but only increases cash for one stockholder and stock holdings for another. Show students a section of the Wall Street Journal’s New York Stock Exchange’s Composite Transactions. If you show the section with Berkshire Hathaway, you can use it to illustrate the effect of not paying either cash or stock dividends, or having stock splits.
LO 4 Discuss why income is not affected by either "gains" or "losses" on the reselling of treasury stock. If the company invests in the stock of another company and sells that stock, a gain or loss is recorded. Explain why the company does not have the same result when it sells its own stock, which many students view as a logical result. Emphasize that the company is dealing in its own equity , not a revenue-generating commodity or investment. When stock is originally sold at greater than par value, additional paid-in capital is created. When stock is repurchased, it is on "hold" in the treasury stock account. If that treasury stock is resold for precisely the purchase price, the net effect is zero. If treasury stock is resold for more than the purchase price, more additional paid-in capital has been created. If the resale is for less than the purchase price, then either the paid-in capital account must be reduced, or lacking an APIC account, in effect a bonus, or dividend, is being given to the stockholders who purchase the stock, so retained earnings is reduced.
LO 6 The idea that total equity remains the same is not always understood by students. Do a "before" and "after" example in class to illustrate. For example, the three stockholders’ equity sections for Shah company in LO 6 in the textbook can be compared on an overhead transparency.
LO 7 Add a stock split to the comparison from the previous suggestion. Prepare another stockholders’ equity section showing the effect of a 2:1 stock split instead of a 100% stock dividend.
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-10 Harcourt, Inc.
Solution
preferred dividends reduce the cash available for common dividends. The fact that these dividends are converted to debt by the time they reach the parent company does not change the fact that they are still an obligation that reduces the cash available for distribution to common shareholders. Of course the company would maintain that they are enabled by these transactions to increase profitability, and that this outweighs the above disadvantage. Common stockholders need to keep an eye on the bottom line and future dividend declarations to determine what real effect if any takes place.
Food for thought: Mandatory redeemable preferred stock Your textbook describes callable preferred stock as preferred stock which the company has the right to buy back (retire) at a specified price. An article in Business Week described another type of preferred stock known as “mandatory redeemable preferred stock,” (MRPS) which the investor can, under specified conditions, require the company to buy back.^1
redemption option. Why then would an investor find the mandatory redemption feature attractive?
Solution
like debt, and has features of both. Students can discuss the differences between equity and debt, and consider the form versus the substance of this financing instrument.
the balance sheet in between equity and debt, so many companies literally leave it hanging there alone in limbo with no label. This is a good question for students to consider because it has no “right” answer.
money without adding debt to the balance sheet. Also, dividends, unlike interest, are not mandatory. The disadvantage is the redemption feature, which could leave the company at the mercy of the investors who have the ability to call back their money at a time that may not be convenient for the company.
seems if the stock has declined considerably in value. The redemption price will have been set by the terms of the stock certificate and may give investors a better choice than the market, a valuable option.
This type of security is another example for students of why it is so necessary to look carefully at balance sheet items. In this case, the reader may have to study the footnotes to realize that this preferred stock is very close to debt—in fact it could under certain circumstances become a current liability—and might change the opinion of a potential investor or lender. This last point can be used to
(^1) Business Week, November 7, 1988, James Norman, “How To Juggle Numbers So the Debt Doesn't Show.”
CHAPTER 11 — STOCKHOLDERS’ EQUITY
Harcourt, Inc. 11-
begin a brief class discussion about off balance sheet financing and how companies can disguise the real nature of balance sheet items if the reader of the statements is not thorough.
Food for thought: Vermont Teddy Bear Co.
In November 1993, Vermont Teddy Bear Co., a privately held company, “went public” by offering 1 million shares of their stock (about 20% of the company) to the public at $7.50 per share.^2 This is known as an IPO, or Initial Public Offering.
they will initially offer their stock for public sale? Is this an arbitrary number?
happens if no one buys at $7.50?
company by offering a 20% stake to outsiders?
to which Vermont Teddy Bear might put the proceeds of the offering?
enable you to make a decision about whether you want to own their stock, how many shares you want, and what price you are willing to pay? Is the product important? (For your information, they sell huggable hand-sewn teddy bears, in a variety of sizes, priced from around $60 at the bottom end, to over $650 at the top end.)
Solution
results, in comparison with similar companies already publicly traded. The price is usually developed with the help of an investment banker. The offering price is in no way arbitrary. The company wants to ask a price that will be acceptable to the public, without undervaluing the company.
event that demand exceeds expectations the company receives more than they expected. For example, Boston Chicken’s IPO, priced at $20, soared to $48.50 by the end of the first day^3. In other cases, the price a company receives may actually be lower than what had been hoped. If it becomes clear that the price is going to be unacceptably low, the company may even withdraw the offering, as Dr Pepper/Seven-Up Cos. did in 1992.^4 Vermont Teddy Bear was a highly successful offering. Trading opened at $10, and went as high as $19, closing at $16.75^5.
means to supply it, and do not wish to, or cannot, borrow.
(^2) The Boston Globe, November 21, 1993, Ronald Rosenberg, “Vermont Teddy Bear Has High Hopes
Stock Offering Won't Hibernate.” (^3) The Wall Street Journal, November 10, 1993, William Power, “Boston Chicken Soars By 143% On
Its IPO Day.” (^4) The Wall Street Journal, July 2, 1992, Bob Ortega, “Dr Pepper Withdraws Stock Offering, Citing
Weakness in the Market for IPO's.” (^5) The New York Times, November 24, 1993, Michael Janofsky, “Vermont Teddy Bears Get a Big Hug
From Investors.”
CHAPTER 11 — STOCKHOLDERS’ EQUITY
Harcourt, Inc. 11-
Company March 24, 2000 52 week high 52 week low K2 7 ¾ 11 5/8 6 3/ Gateway 58 84 28 3/ McDonald’s 35 3/16 49 9/16 29 13/ The Gap 47 13/16 53 ¾ 29 5/ Circuit City 47 7/8 53 7/8 29 5/ PepsiCo 33 ½ 41 ½ 29 11/ Time-Warner 101 1/16 104 11/16 57 3/ J. C. Penney 15 7/16 54 7/16 13 5/ Coca Cola 47 70 7/8 42 7/ Whirlpool 58 78 ¼ 48 5/ IBM 115 ¼ 139 3/16 81 1/ Wrigley 73 7/16 98 59 7/
Stock prices change for a wide variety of reasons. Stock splits, changes in the economy, world affairs, consumer habits, acquisitions or dispositions of business segments, weather, can all cause a company’s stock to rise or fall. Students’ attention should also be directed to factors like the relative prices of stock. Some are very high-priced, some very low.
If students are interested in understanding stock quotes and the various symbols and information in The Wall Street Journal , the Journal publishes a booklet, offered free to educators, that explains stock quotes in easy-to-read language. They will send a number of copies on request. (See bibliography.)
Ethical discussion: Insider trading
There have been many “insider trading” scandals in the news. Do you really understand what the term means, and what was wrong with the actions taken by these individuals?
your own words, without going to reference materials just now.
does it differ from your original understanding?
Summarize what happened in each. What did the people involved do? Why was it considered wrong? Were there mitigating circumstances? Did the parties involved argue that they were not wrong? If so, what justification did they offer?
trading investigations and prosecutions in terms of the:
between them.
Your company is going to sell one of its subsidiaries, based upon the discovery of a new technology, to the larger company, which is in a better position to manufacture and market the product. These negotiations have not as yet been made public. Everyone in your office is talking about buying as many shares in the subsidiary as they can because, when the sale takes place, the stockholders in the subsidiary will be bought out by the larger company at a very advantageous price. Is this insider trading? Why or why not?
Solution
question in class before students research the remainder of the exercise, and note down their responses.
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-14 Harcourt, Inc.
transactions based on privileged information, gained by one's position and not available to the public. When such transactions affect the price, giving an unfair advantage to the trader, it is illegal."^9
investor having the same opportunity to gain or lose based on their own research into publicly available information and their actions based on this research. If we assume this is true, then anyone who has access to information that others cannot obtain will gain an unfair advantage over all other investors, and the investors without inside information cannot do as well. This harms the investors without privileged information and the market in general if these trades influence the stock’s price.
the details.
the very fact that it is so common makes it difficult for regulators to detect and prosecute offenders. Too many sources of information have limited distribution. The cases that are found out and prosecuted are those that involve substantial amounts of money, or many participants, making them obvious. Also certain individuals, such as those involved in the securities industry, are watched more closely than those more removed from the regular buying and selling of stocks. If too many shares change hands and the trades all seem to center around a related group of people, such as people who all work for the same company, they draw attention to themselves. However, the legal actions focus on the effect the trading has on the market price, so that it is only the larger operations that stand out. The smaller cases profit individually (this does not justify the practice) but have little measurable effect on the market, even for the individual stock in question.
information that has not been made available to all investors. The only way to get out of this is if every one of the shares not held by your company is held by an employee of your company who knows about these negotiations. This is unlikely. However, if the employee trades are relatively minor in number of shares and do not have any significant effect on the market, then the actions would not be considered illegal, by the definition.
Food for thought: IBM on Black Monday, October, 1987 Late in October of 1987, it was revealed that IBM planned to buy up to $1 billion of its own stock. This news came just a few days after the now-legendary “Black Monday” stock market crash. IBM said that the buy-back had been planned previously, and was not related to the market fall.
They considered their own stock to be a good long-term investment. However, the article noted that many firms were buying large quantities of their own stock in the wake of the market decline.^10
a serious decline in market values?
(^8) Jerry M. Rosenberg, Dictionary of Investing, New York: John Wiley & Sons Inc., 1993. (^9) Ibid. (^10) The Wall Street Journal, October 28, 1987.
FINANCIAL ACCOUNTING INSTRUCTOR’S MANUAL
11-16 Harcourt, Inc.
they intended to send you cash? Why or why not? What is the difference between this situation and a declared stock dividend? Solution
hopes (probably correctly) that the stock will recover its market price before the dividend, or close to it, and their shares will be worth more in total. For a large stock dividend, the market price often also increases enough after the dividend to give the shareholder more total market value than they had before the dividend. However, the increase in market value in both cases is merely “paper gain,” not an increase in cash, until the shareholder actually elects to sell some of the stock. The company has not paid out retained earnings, but has reinvested them permanently in the company, in the shareholders' names, by distributing a stock dividend. This unrealized gain cannot be determined, or thus taxed, until shares are sold and an actual dollar amount realized.
company declared a cash dividend, a distribution of earnings, in a set amount. The fact that the shareholder in effect asks the company to take his or her gain and buy some stock for it and send that to the shareholder does not alter this. Thus it is taxable like a cash dividend. The difference is in the intent of the company, and the way the dividend is expressed (cash or stock).
Food for thought: Reverse split You have learned about stock splits, their purposes, and their results. Now consider a “reverse split.” What do you think this might be? Why do you think a company might consider one? Look for a recent example of a company activating a reverse split. Explain what happened, and why. Solution A reverse split occurs when a company reduces, rather than increases, the number of shares outstanding. This would of course increase the par value and the market value of each share. The company may be concerned about an erosion in the price of its stock, especially in relation to the stock of companies they consider to be comparable. The decrease in the number of shares available should correct this although it is not guaranteed to accomplish this any more than a regular stock split will always necessarily lower the price to a desired level.
In-class exercise: Components of Stockholders Equity Review the stockholders' equity section of Whirlpool’s 1998 balance sheet.
Stockholders’ Equity Common stock, $1 par value: 250 million shares authorized, $ 85 Paid-in capital 321 Retained earnings 2, Unearned restricted stock (3) Cumulative translation adjustments (241) Treasury stock – 6 million shares at cost (241) $2,
CHAPTER 11 — STOCKHOLDERS’ EQUITY
Harcourt, Inc. 11-
Does it mean the same thing?
Solution
